S&P warns stock exchanges: clean up your technology glitches

Standard & Poor's has just released a very interesting report with a pointed warning to all the stock exchanges in the U.S.: exchanges that have significantly more technical problems than others could lose market share as investors lose confidence in the exchange.

Why would S&P do a report on technical glitches at exchanges? Because it could affect the credit rating of the exchanges: "as technical problems occur more frequently, operational risk is becoming a more important component in our analysis and could result in downward pressure on ratings over the next few years."

S&P counted 13 "Operational Issues" at U.S. exchanges over the past 18 months, including issues at BATS, Direct Edge, the CBOE, the NYSE, and NASDAQ.

S&P concludes that there are three reasons the exchanges--and exchange members like Knight, Goldman Sachs, and others--are seeing more technical glitches:

First, new competitive dynamics. Reg NMS, which went into effect in 2007, introduced more competition to exchanges. There are now 16 stock exchanges and 50 alternative trading platforms, including dark pools. Market share has been falling for the the two main exchanges, the NYSE and NASDAQ.

Second, changes in market structure. The market is now more fragmented, but all those trading venues have to connect with each other. Interconnectivity problems at one exchange can and does affect the ability of other exchanges to function. When the public feed for NASDAQ went down on August 22, all the other stock exchanges also had to stop trading NASDAQ-listed securities.

Third, advances in trading technology. Exchanges have invested heavily in new trading technologies, much of it designed to be able to trade faster and to be able to process millions of transactions daily. This has greatly increased the complexity of the trading systems. They conclude that "faster trade speed and greater interconnectivity are amplifying the impact of operational glitches when they occur."

So what will likely happen? They are short on recommendations, but they do believe that tougher regulatory standards are coming, including the likely adoption of Reg SCI, which would require that the technology used in all the exchanges met uniform standards and were continuously tested, and provide certain notifications in the event of systems disruptions and other events.

They also believe that exchanges will likely adopt "kill switches" between brokers and exchanges that can shutdown trading quickly in the event of a snafu. The lack of a "kill switch" was one of the major reasons Knight's computer glitch in August 2012 turned into a disaster that almost brought the company down.

What's the bottom line? S&P is not lowering their ratings on either the NYSE or NASDAQ, but they do believe that "rising operational risk is becoming a more important factor in our ratings" and that "exchanges whose operational risk exceeds industry averages could see rating actions down the road."

More importantly, they made it clear that if one exchange has more technical problems than another, it could make the difference between survival...and extinction: "With competition heating up, the ability to ensure seamless operations could go a long way toward determining which exchanges will come out on top."